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State Budget Straitjacket Tightens

Don’t expect state governments to contribute to economic growth again for a decade. The fact is, most state and local governments face an overwhelming challenge -- one that will mean belt-tightening and limits on spending for years to come. They’re short $1 trillion -- maybe more -- in promised pension payments to government workers who have already retired or will someday. A study by professors at the University of Chicago and Northwestern University estimates that the shortfall is actually about $3 trillion.

Just as the retirement of baby boomers will accelerate benefit payments in Social Security, so, too, the imminent wave of retirees will put demands on public pension plans. Andrew Biggs, a fellow with the American Enterprise Institute, says, “Public pension plans won’t go broke tomorrow. The worst won’t go broke until 2019 or 2020, but taking action requires a long lead time.”

Analysts think that New Jersey may be in the worst shape, having recently missed a deadline to add $3 million to its pension fund. But it has plenty of company, including large states such as Illinois and California. Making matters worse is that many states assume an 8% return on their investments and have fallen far short of that in the past couple of years. Public pension plans can also project those returns over 30 years, which makes the shortfall appear smaller than in the private sector where company pension plans are measured over a 10-year horizon.

States will be feeling more pressure to reestimate their pension obligations as federal regulators get involved. The Securities and Exchange Commission recently took action against New Jersey, saying the state made a false claim that it was funding its workers’ pension funds. No penalties were imposed, but such action, the first by the SEC against a state, could make it more expensive for the state to sell bonds. The SEC is continuing to look at other states.

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To replenish funds, states will need to increase taxes, reduce spending and find some way to rein in retiree benefits. But each option to control benefits is sure to encounter fierce resistance. Few voters embrace tax increases. Budget cuts incur the wrath of those affected by reductions. And reeling in benefits to former and current state employees is nearly as tough. When Colo., S.D. and Minn., for example, cut back on cost-of-living adjustments for pensions, each was sued. Several states have successfully pushed back the age when new employees will qualify for a full pension, but that won’t have an impact for decades.

Some states are pondering whether to put workers into 401(k) plans. But there’s resistance to that from employees who saw the drop in value of 401(k)s held by workers in the private sector over the past few years and don’t want to risk a similar outcome. What’s more, a conventional pension plan is seen as a necessary attraction for hiring teachers and police officers.

State workers will push for federal bailouts, but given huge federal deficits and growing pressure on lawmakers to slow spending, it’ll be no easier to convince national lawmakers to come up with the money than it will be to coax a fix from state legislators.

As a result: A long-term drag on the country’s economic growth. Spending by state and local governments accounts for about 11% of gross domestic product, about twice the impact that the housing industry had in its heyday a few years ago. Since the recession began, states have added to GDP in just three of 10 quarters. In the past two years, states cut spending by a total of $75 billion, with billions more in cuts to come this year. There’s been little change in revenues in three years. And Medicaid spending has risen 21% in three years, says Ray Scheppach, executive director of the National Governors Association.